Notice 2004-52

Request for Information About Credit Default
Swaps

I. PURPOSE

This notice requests further information regarding certain financial
transactions commonly known as credit default swaps in connection with the
consideration by Treasury and the IRS of taxpayer requests for specific guidance
on the tax treatment of credit default swaps.

II. BACKGROUND

A credit default swap (CDS) generally refers to a contractual arrangement
in which one party (the protection buyer) buys from a counterparty (the protection
seller) protection against default by a particular obligor (the reference
entity) with respect to a particular obligation (the reference obligation).
Typically the protection buyer either pays a single lump sum, or it pays
periodical regular fees either until a defined credit event occurs or until
the maturity of the CDS if no credit event occurs. Following the occurrence
of a credit event, the protection seller typically either pays the protection
buyer an amount reflecting the reference obligation’s loss in value
from the date the CDS was established or purchases from the protection buyer
at a pre-determined price an obligation (the deliverable obligation) that
is expected to approximate the post-credit-event value of the reference obligation.
Although certain standard contractual terms and conditions may be used, the
reference obligation, the deliverable obligation, the credit events covered,
and the protection seller’s obligation upon the occurrence of a credit
event are all matters of negotiation between the parties.

A large international market for CDSs has developed. Market participants
include commercial banks, broker-dealers, insurance companies, hedge funds,
and special-purpose securitization vehicles such as synthetic collateralized
debt obligations. Commercial banks may buy protection in order to manage
credit risk associated with a particular loan and may sell protection in order
to acquire synthetic exposure to other loans. Broker-dealers may buy and
sell protection in the course of providing market liquidity. Insurance companies
may buy and sell protection both in the conduct of their investment activities
and in the conduct of their insurance activities. Hedge funds may buy and
sell protection in order to manage risk, speculate, or acquire synthetic exposure.
Securitization vehicles may sell protection in order to acquire synthetic
exposure.

Recent news reports suggest that market participants are considering
the creation of CDS indexes through which participants could buy and sell
protection on a defined basket of credit exposures on standardized terms.

Several market participants have requested specific guidance regarding
the tax treatment of CDSs. Treasury and the IRS recognize the significance
of the CDS market and are aware that the market is rapidly evolving. Treasury
and the IRS believe that CDSs deserve careful study so that appropriate guidance
can be issued.

III. TAXPAYER REQUESTS FOR GUIDANCE

Several taxpayers and industry groups have requested guidance on the
tax treatment of CDSs and the taxpayers that enter into them. Among the questions
they have raised are:

whether amounts paid by a U.S. protection buyer to a foreign protection
seller constitute income that is subject neither to withholding nor to the
insurance-premium excise tax;

whether a protection seller could be considered to be engaged in a trade
or business within the United States by virtue of entering into CDS agreements;

whether a CDS gives rise to:

passive income for purposes of the passive foreign investment company
rules;

qualifying income for purposes of the publicly traded partnership rules;
or

unrelated business taxable income; and

the timing of recognition of income for the protection seller and expense
for the protection buyer.

The concerns raised relate particularly, although not exclusively, to
the treatment of payments from a protection buyer within the United States
to a protection seller outside the United States. In response to these taxpayer
requests, Treasury and the IRS are thoroughly analyzing all of the tax issues
raised by CDSs and expect to issue guidance.

Submissions generally have argued that the legal rights and obligations
under a CDS are sufficiently analogous to those in other types of existing
financial transaction that the tax treatment of the analogous transactions
should govern the tax treatment of a CDS for all purposes of the Code. See, e.g., Bank
of America v. United States, 680 F.2d 142, 149-50 (Ct. Cl. 1982)
(commissions for bankers’ acceptances sourced for foreign tax credit
purposes in same manner as interest because predominant feature of acceptance
is substitution of credit and because interest is closest analogy in source
rules).

Some possible analogies for a CDS include a derivative financial instrument
such as a contingent option or notional principal contract, a financial guarantee
or standby letter of credit, and an insurance contract. A variety of theories
have been advanced in the existing literature both for and against these analogies.
Other commentary recommends an alternative to the analogue approach. Following
is a brief survey of some of the theories that have been advanced.

A CDS has been analogized to a contingent put option that the option
buyer is entitled to settle either for cash value or by physical exercise
with respect to the deliverable obligation following the occurrence of a credit
event. Option premium generally is not subject to withholding. Trading in
such options may not give rise to a “trade or business within the United
States” pursuant to the securities-trading safe harbor under section
864(b).

A CDS has been analogized to certain notional principal contracts providing
for contingent nonperiodic payments. Some commentators have argued that CDSs
with periodic payments, among other features, meet the definition of a notional
principal contract; however, commentators disagree about the scope of CDSs
that may fall within the definition of notional principal contract. Payments
with respect to a notional principal contract generally are not subject to
withholding. Trading in such notional principal contracts may not give rise
to a trade or business within the United States. Special timing rules may
apply to notional principal contracts.

A CDS has been analogized to a guarantee. Guarantee fees have been
analogized to commissions for letters of credit, which are sourced in the
same manner as interest. See Centel Communications Co. v. Commissioner,
920 F.2d 1335, 1343-1344 (7th Cir. 1990) (citing Bank of America).
In addition, guaranteeing obligations and issuing standby letters of credit
from within the United States could constitute engaging in a trade or business
within the United States. Some commentators have distinguished CDSs from
guarantees on the basis that a credit event under a CDS requires performance
by the protection seller without regard to whether the protection buyer sustains
an actual loss. A relevant factor in this regard may be how much of the CDS
protection-buying market consists of persons who do not have or expect to
be exposed to credit risk.

A CDS has been analogized to a form of insurance. Insurance premiums
paid to a foreign person with respect to a U.S. risk are subject to excise
tax. Moreover, insuring risks from within the United States could constitute
engaging in a trade or business within the United States. Some commentators
have distinguished CDSs from insurance on the basis, as described above, that
no actual loss need be sustained in order to give rise to an obligation under
a CDS. Some commentators have noted the Supreme Court’s opinion in Helvering
v. LeGierse, 312 U.S. 531 (1941), that the essence of insurance
activity is the shifting and distribution of insurance risk. These commentators
have suggested that many protection sellers do not shift or distribute risk
with respect to CDSs in this way, and that it is not clear how a protection
buyer could know how its counterparty manages risk with respect to a particular
CDS.

Some commentators have suggested consideration of an approach to determine
the tax treatment of CDSs other than classification by analogy to other types
of financial transaction. Instead, they have proposed that the tax treatment
of payments with respect to a CDS could be determined by analyzing various
elements of the CDS transaction, including the nature of the reference obligation
and whether a party to the CDS provides financial services to customers.

IV. REQUEST FOR COMMENTS

The foregoing brief overview indicates that the economic similarity
of a CDS to various financial transactions tends to blur the distinctions
between possible analogies and that the various analogies correspond to significantly
different tax treatment.

Treasury and the IRS believe that additional information is needed in
order to respond to taxpayer requests for specific guidance regarding the
appropriate tax treatment of amounts paid and received with respect to a CDS.
Treasury and the IRS are particularly interested in information regarding:

DRAFTING INFORMATION

The principal authors of this notice are Paul Epstein, Theodore Setzer,
and Steven Jensen of the Office of Associate Chief Counsel (International).
For further information regarding this notice, contact Mr. Epstein, Mr. Setzer,
or Mr. Jensen at (202) 622-3870 (not a toll-free call).